Trading ETFs: Seven rules of the road

By Paul ChinAugust 2015min read

The significant growth trajectory of the Australian exchange-traded fund (ETF) market is evidence that advisers and investors alike are gaining more confidence in trading ETFs. But how do you know if your trades are the most efficient and effective they can be?

Although ETFs effectively blend the investment characteristics of managed funds with the trading flexibility of individual stocks, they trade somewhat differently than either of those assets. Trading strategies are more important for ETFs than for managed funds: the timing and type of trade can affect the price at which the ETF is bought or sold, which is not the case for managed fund investors.

(Editor’s note: To learn more about the features, benefits and risk of ETFs, take the free ASX online course on Exchange-traded funds and Exchange-traded products).

Vanguard’s Investment Strategy Group recently published a research paper based examining how the ETF market works. The research delivered seven strategies that can help ensure your ETF trading is offering the best chance of investment success.

1. Use “marketable” limit orders instead of market orders

Limit orders involve selecting a certain execution price you are comfortable with. They offer advantages over market orders as they provide greater price control and protection. Using "marketable" limit orders ensures you are not buying above or selling below your set price. A “marketable” limit order is not a conventional or defined instruction in Australia, but is a form of a limit order (or a trading approach) that may offer a higher likelihood of execution.

2. Pay attention during volatile periods

Wide swings in the market can cause the prices of an ETF's underlying shares to move sharply, resulting in wider bid/ask spreads for the ETF or larger premiums and discounts to fair value. In these situations, the price control offered by limit orders becomes extremely beneficial.

3. Beware of the open and close

The ASX opening and closing prices for ETFs are determined by a complex calculation that factors in things such as overnight market moves and recent global news, so you need to be cautious when trading before 10.15am and after 3.45pm (Sydney time).

At market open, all the underlying securities in the ETF may not have started trading. This can potentially mean wider bid/ask spreads due to pricing uncertainty.

Similarly, as the market approaches close, an ETF may experience wider spreads and more volatility as market participants begin to limit their risk, leading to fewer firms “making markets” (i.e. supporting the ability to buy or sell a particular share at the quoted bid and ask price) in an ETF. This means you should avoid waiting until the last few minutes to wrap up buy or sell orders in the afternoon.

4. Tune out the volume

ETFs with substantial trading volume and narrow bid/ask spreads may appear to offer superior liquidity. However, an ETF's average daily volume (ADV) is not the only gauge of its liquidity. An ETF's bid-ask spread can be a better indication of liquidity because it factors in the liquidity of an ETF's underlying shares, as well as the associated costs for authorised participants (APs), whose role is to create and redeem the actual units of the ETFs on behalf of the ETF provider.

5. Your broking firm's institutional trading desk can help tackle a large trade

The on-screen volumes for ETFs are rarely a true representation of the trade size you are able to achieve. When trading ETFs in larger amounts (i.e. 10,000 units or more), your broker can help get the best execution by accessing additional liquidity.

For example, they may be able to find and access unseen liquidity in the market or complete the trade in smaller chunks.

6. For trading international ETFs, it's a matter of time

Where possible, it is better to trade international ETFs at times that coincide with the trading hours of the underlying shares' local markets. Prices of international ETFs traded in Australia tend to be closer to the value of the underlying shares and typically trade with narrower bid-ask spreads when their respective markets are open and overlap with Australian trading hours.

While Australian ETFs trade from 10.00am to 4.00pm (Sydney time), Asian markets open late in the Australian morning, and European and western hemisphere markets are not open during Australian trading hours. This means that spread levels may be wider for some international ETFs because of pricing uncertainty.

7. When in doubt, call for help

Keep in mind that assistance is available when trading ETFs. Investors may encounter issues or questions that are not covered by the trading best practices outlined here. They may also unknowingly face higher frictional costs when trading larger ETF unit amounts, and it is important for investors to focus on controlling these costs. Rather than go it alone, investors should consider reaching out to their brokerage platform or to the ETF provider for assistance.

About the author

This article appeared in the August 2015 ASX Investor Update
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This article appeared in the August 2015 ASX Investor Update email newsletter. To subscribe to this newsletter please register with MyASX.

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